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At-Risk Limitation on Deducting an LLC Member’s Losses

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Tax Section

Editor: Albert B. Ellentuck, Esq.

Before the advent of LLCs, the at-risk
rules were for the most part a poor stepchild when
it came to loss limitations. If a partner could
avoid application of the passive loss rules and
the basis limitation rules, the at-risk rules
seldom created a problem. Accordingly, the IRS and
Treasury have made little effort to provide
guidance in the at-risk area. The at-risk
regulations are predominantly proposed and
temporary regulations that have been on the books
for many years without being finalized.

However, the at-risk rules may frequently limit
the ability of LLC members to deduct losses. This
is largely the result of the at-risk provision
that denies members in LLCs taxed as partnerships
at-risk basis for their share of LLC nonrecourse
debts. Since all LLC debt is generally nonrecourse
(either true nonrecourse or exculpatory), most LLC
members can deduct only cash out-of-pocket LLC
losses under the at-risk provisions. Treasury has
indicated that it expects to review the at-risk
rules and regulations in the near future.

The at-risk rules apply to individual taxpayers
and closely held corporations under Sec.
465(a)(1). Consequently, an LLC itself is not
subject to the at-risk rules. However, those rules
are applied at the individual member level to
losses passed through from the LLC.

The
at-risk rules were designed to prevent the
deduction of losses when the taxpayer is protected
from suffering an actual out-of-pocket loss. When
the at-risk rules were first enacted by Congress,
the rules applied only to the following activities
(Sec. 465(c)(1)):

These five areas were
considered at the time to be the most fertile
ground for tax-shelter abuses. Then in 1978,
Congress extended the at-risk rules to all other
activities except real estate. Finally, as part of
the Tax Reform Act of 1986, P.L. 99-514, the rules
were extended to cover real estate activities in
certain circumstances. The at-risk rules now apply
to all activities engaged in as part of a trade or
business or for the production of income (Sec.
465(c)(3)).

Note: The at-risk rules
generally apply to losses incurred after December
31, 1986, with respect to the activity of holding
real property that the taxpayer placed in service
after that date. Under this general rule, as long
as the real property used in the activity was
placed in service prior to the end of 1986, the
at-risk rules do not apply to post-1986 losses,
even if the losses are attributable to nonrecourse
financing incurred after 1986. However, in the
case of a partnership or LLC interest acquired
after December 31, 1986, these rules apply to all
losses incurred after 1986 that are attributable
to real property owned by the entity, regardless
of when the entity placed the property in
service.

Determining What
Constitutes a Separate Activity

Since the
determination of amounts at risk generally is made
on an activity-by-activity basis, it is important
to understand what constitutes a separate activity
and what activities can or must be aggregated for
at-risk purposes. (Activities for purposes of
applying the at-risk rules may not be the same as
activities defined by the passive loss
regulations.)

The Code specifically treats
each of the original five activities, except the
leasing of tangible personal property, as a
separate activity. This means that each project in
each one of the five listed categories is treated
as a separate activity (e.g., each film and each
oil and gas property). An LLC involved in the
activity of leasing tangible personal property
must treat all leased assets placed in service in
a single tax year as a single activity (Sec.
465(c)(2)(B)).

Members in an LLC can
aggregate all activities conducted by the LLC in
any of the original five at-risk activities except
equipment leasing (Temp. Regs. Sec. 1.465-1T(a)).
For example, if the LLC operates five oil wells, a
member can aggregate them into one activity. If
the LLC also distributes three films, the three
films can be aggregated into one activity;
however, the film activity and the oil well
activity cannot be aggregated.

If a
taxpayer is conducting activities other than the
original five at-risk activities or real estate
activities, and the activities constitute a single
trade or business, they must be aggregated as one
activity if either:

The taxpayer
actively participates in management of the trade
or business; or

The trade or
business is carried on by a partnership, an LLC
classified as a partnership, or an S
corporation, and 65% or more of the losses for
the tax year are allocable to persons who
actively participate in the management of the
trade or business (Sec. 465(c)(3)(B)).

Factors that indicate active participation
include:

Participating in decisions
involving performing services for the trade or
business;

Actually performing
services for the trade or business; and

Hiring and discharging employees (this must
include employees other than the manager) (Joint
Committee on Taxation, General
Explanation of the Revenue Act of 1978
(JCS-1-79), p. 131 (March 12, 1979)).

Handling Real Estate
Activities

All real estate held by a
taxpayer is considered a single activity. This
rule does not apply to real estate held in
connection with any other activity. In other
words, if real estate is held in connection with
an oil and gas activity or an active trade or
business activity, it is included in that activity
rather than in the activity of holding real
property.

Aggregating At-Risk
Activities

While a member in an LLC usually
wants to treat activities as separate under the
passive loss rules, it generally is preferable to
aggregate activities for at-risk purposes. This
provides the member with the largest “pool” of
at-risk basis against which losses can be
deducted.

Example: B and
T form
G LLC
to operate several farming properties in the
Midwest. G is classified
as a partnership for federal taxes and operates
three farms, X, Y, and Z. B’s share of
the income and loss from each farm property for
2011 is shown in the exhibit. B’s amount at
risk with respect to G at the end of
2011 is $12,000, with $4,000 allocated to each of
the three farm activities. If G does not
aggregate the three farm activities, each is
treated as a separate at-risk activity. Because
the losses passed through from X and Y exceed B’s at-risk
basis in those activities, B cannot
deduct $4,500 of the X loss and $500
of the Y
loss.

If G
aggregates the three activities, B has net
income from the aggregated activity of $22,700,
and no at-risk limitation applies.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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